By GRAHAM FROST 12/03/2009
The Bank of England announced recently that it would resort to unusual measures to resolve the banking crisis. As interest rates approach zero, this is all that’s left in its armoury to get banks lending again and the economy moving.
The scheme is one of quantitative easing, or money creation, on a grand scale. The Bank has said that it will purchase bonds of up to £150bn from financial institutions. If banks receive cash for these, the idea is that they should be more inclined to lend it as leaving it on their books at zero interest is not very appealing. £100bn of the purchases is destined for the gilt market and £50bn for the quality corporate bond market and the money will be phased in over a few months. What is the likely impact of this policy?
The gilt market had the biggest one day rally since 1997 on the announcement, with the yield on 10 yr gilts dropping to 3%. That was without the Bank actually doing any purchases (they begin on 11th March) and achieved one objective- a lowering of medium to long term rates on which loans to businesses and consumers are based. The next step is to get the banks to lend the cash they get. That raises several issues.
Firstly, the banks may prefer to hold bonds rather than exchange them for cash. If they do sell them for cash, they may prefer to hoard it rather than lend it. The private sector may not want to borrow and may prefer to save, so the banks still sit on cash. Perhaps foreign bond holders take the opportunity to dump their holdings, so the money leaves the UK. The end result is a boost to money supply and lower long term rates but no significant economic stimulus. If the policy is successful though, inflation should pick up and that will lead to a sell-off in bonds, causing large losses for the Bank, who will at that time be trying to withdraw stimulus by selling the bonds they bought! One solution to all this is that the government forces the banks to sell the bonds now and to buy them back later and forces them to lend the cash in the interim. Sounds like China? Well, the banks there too are government controlled.
What are the preferred assets to invest in? That depends on your view of inflation. In the short term it inflation is likely to fall into negative numbers globally. To pick up again, you would need to see an economic revival where not only commodities and energy pick up, but also wages. That seems some way off. So, given that we have a big buyer in the market, gilt yields could go even lower or at least not rise. That would hopefully lower investment grade yields too, thereby increasing their prices and, if not, the same buyer can see to it. A big step forward would for government to provide some clarity on what guarantees holders of bank bonds will have. Lowering credit costs and improving its availability is a precursor of economic improvement. Eventually, equities should benefit.